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Why you need to think outside the GAAP

By Chris Bryan

Are you struggling to see the benefits of your lean initiatives? If so, you’re not alone. You started your lean journey with the expectation that the benefits would flow to the bottom line. Unfortunately, the early financial numbers may not be what you expected.

Many companies abruptly take an exit from their lean journey when early indications don’t show expected benefits. Implementing the principles of lean is a long-term initiative, however, and will ultimately provide a significant competitive advantage—but it will test your vision and leadership mettle.

Lean principles

The goal of implementing lean principles is to find and eliminate waste along the value stream. Most companies appoint a lean champion. Employees are trained and lean teams are formed to map key production processes. This process is called value stream mapping.

The objective is to identify steps and resources that add no value to the consumer of your product. Once non-value added steps are identified, the value stream map is redesigned and waste in the process is eliminated. Production planning changes dramatically. Manufacture-for-stock is reduced or eliminated in favor of manufacture-to actual-demand. When a lean team has redesigned the process, an implementation event, or kiazen event, is planned to execute the changes.

Kiazen events usually take one to several days of intense work. When the event is complete, production resumes using the new lean production flow. It is common for lean teams to shorten manufacturing times, free floor-space, reduce in-process part movement and shrink (or eliminate) inventories. Compelling evidence shows that firms, large and small, benefit from implementing lean principles.

Nothing rivals the excitement and energy generated during the early stages of a lean journey. You will feel great about gathering your employees for training, forming lean teams and redesigning your value stream maps, and everyone will be eager to participate in the initial kiazen events. The optimism is intoxicating. Soon, however, you will face the task of measuring the progress of your lean initiatives.

Challenges measuring lean initiatives

Looking to your standard financial statements in the first few months of a lean journey is likely to give you a confusing picture. Unfortunately, standard accounting methods don’t reflect the progress made by lean teams in the early stages.

Costs associated with training employees, reconfiguring production space, relocating inventory, and conducting kiazen events all hit the profit and loss statement immediately. Liquidating excess inventory, an important initiative in lean, may hit profit margins and increase trade accounts receivable in the short-term.

Worthwhile lean projects that may not result in significant costs, such as clearing production floor-space and establishing point-of-use inventory locations, may not result in immediate cost decreases (rent or depreciation).

If that isn’t enough, standard production cost accounting methods actually reward operations managers for over-producing. Often, manufacturing overhead allocations are based on direct labor hours and other activity-based metrics.

When lean teams work to reduce excess inventory, production quantities may decline, direct labor hours and other metrics may decline and create unfavorable absorption variances. When new, lean production processes are implemented and production is limited to actual customer demand, unfavorable variances may persist.

The good news is that variable manufacturing costs can be reduced immediately; however, it takes time for you to reduce semi-variable and fixed costs that make up the manufacturing overhead pool.

When your generally accepted accounting principles (GAAP) financial statements and traditional product cost reports don’t represent the early progress being made, it’s easy to be distracted from the ultimate goal. To keep your direction and focus, develop a system of specific measures that will ultimately drive broader measures of performance.

Use specific measures to motivate

It is necessary, especially at the beginning of a lean journey, that you implement a system of measurements that can be communicated back to your lean teams. Specific measures and short-term incentives based on achievement are key tools to motivate your lean teams to exert extra effort, develop creative ideas, and to challenge inefficient but deeply entrenched processes.

These measurements will encourage you and your staff to keep driving the right events even when your financial statements do not yet show the fruits of your labor. The benefits of implementing lean principles will, in time, improve your financial statements and become a testament of your leadership skills.

Considerations in measuring lean

Shareholders, owners, partners and other financial stakeholders all rely on your financial statements to measure the performance of your operation. It’s a great advantage when you can link the benefits of your lean activities directly to improving numbers and trends from your audited or reviewed statements.

This is especially true if your business needs to acquire new, more efficient equipment through financing. Consider preparing a three-tiered reporting pack that links production-floor activities to broader performance measures that drive financial metrics.

The first tier reporting can be used to summarize each kiazen event. The summary should include a brief description of the event and how the changes implemented are expected to benefit either the profit and loss statement or balance sheet. (For example, the event may reduce costs or lower inventory.)

The expected cost and benefit of the event can be estimated with your accountant, but the estimate need not comply with traditional accounting rules. One of the benefits of documenting specific kiazen events is that it allows lean champions to later revisit the event and check if the results are meeting or exceeding the estimate.

The second tier can present monthly lean team metrics that don’t show up on financial statements, but will drive the top-tier metrics directly derived from the financial statements. Examples of middle-tier metrics to support inventory reduction metrics include takt time, consigned inventory value, and JIT supplier performance.

The top tier should contain four to six broad measurements of business performance that can be derived with at least one key piece of information from the financial statements such as sales per employee, inventory turns, return on net assets, return on sales, profit to operating cash conversion ratio, and gross profit margin.

Your vision and focus will become evident over time. One of the most significant and often immeasurable benefits of implementing lean, however, is the ability to take advantage of market opportunities in your industry. Lean initiatives can provide your company with additional capacity to capture new customers and make solid gains in market share.

This reporting pack proposal will help you concentrate on the proper metrics early in your lean journey. If you maintain focus, your business will gain a substantial advantage against your competition through operational excellence and market leadership.

Chris Bryan is a CPA and CFE with Christopher S. Bryan CPA, Inc. offering CFO services and fraud prevention services to local and national clients. He is a six-year veteran of measuring and reporting the lean journey. He can be contacted at 904-437-7022, cbryan@christophersbryancpa.com or through www.christophersbryancpa.com.

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